CTAs: Diamonds during the rough

Global investors had a wake-up call in 2008. As asset classes from equities and corporate bonds to commodities and real estate simultaneously suffered record losses, it seemed diversification as a strategy had failed. In short, these diverse asset classes experienced drawdowns as deep as 66% of their value. Some types of hedge funds, such as convertible bond arbitrage or long-short equity, experienced losses of 32%. It seemed that there was nowhere to hide from the global, panic-induced selling that resulted from the market turmoil that culminated in the demise of Lehman Brothers. Even after the markets started to recover, losses were significant, with losses ranging from -15.9% to -19.4% to the S&P 500, the MSCI world equity index, and the S&P GSCI commodity index for the three years ending December 2009 (see “Diamonds in the rough,” below).

Although these “risk on” assets earn high returns over time, they can suffer during times of increased systemic risk. In 2008, a decline in liquidity and credit availability led to forced liquidations and bid-ask spreads as wide as 30% of the value of secondary trading of hedge funds and private equity limited partnerships.

Gates were erected, meaning that investors who had fulfilled their lock-up period wrongly assumed that they would be able to redeem their interests in hedge fund or real estate holdings. Formerly liquid assets, such as money market funds or stock index funds, faced restricted redemptions given holdings in the massive debt of Lehman Brothers or securities lending programs.